Attractive dividend growth and an influx of mergers and acquisitions are two reasons why investors might want to back the UK equity market, according to Schroders fund manager Bill Casey.
In recent years, the UK equity market has been strongly out of favour and data from the Bank of America Merrill Lynch’s fund manager survey shows that global investors have been underweighting the region since 2014.
The largest underweight positions have come in the past two years after Britain made the decision to leave the EU and the lowest allocation came in March this year as 42 per cent of those surveyed revealed they were underweight the region.
Meanwhile, UK inflation peaked at the end of last year and is down to 2.3 per cent yet while the Bank of England (BofE) decided not to raise interest rates earlier this year after the release of weaker-than-expected economic data, some are concerned that inflation could be a lingering problem globally as well as in the UK.
UK inflation fan chart
Source: Bank of England
From a global perspective, or more specifically in dollar terms, the UK has not performed as badly as it has since the referendum since the mid-seventies, said Casey.
He added that psychologically speaking, “in the UK we’re close to despair when you compare it to places like Europe and the US.”
However, Casey, who co-manages Schroder UK Alpha Plus and Schroder European Equity Absolute Return, believes the UK equity market does have a positive outlook if investors can look beyond price-to-earnings ratio (P/E) or its cyclically-adjusted variant (CAPE).
“On a 10-year view, the UK’s current valuations is a good place to be,” he explained. When he refers to valuations he is referring to a company’s cashflow and dividend growth.
“The P&L [profit & loss] is not the way to look at these businesses anymore, the way to look at it is cashflow and dividend growth. The UK has been distorted in that regard,” said Casey.
And concentrating on cashflow, the Schroder manager said there is reason to be bullish that over the next few years UK dividends can grow.
UK dividends are already at high levels and were over 4 per cent for the first quarter of the year, while UK 10-year government bond yields did not manage to reach 2 per cent over the same period making it the highest premium seen since the Second World War.
He added that UK equity dividends are more than two times US equity dividends and that “you need to go back to the 1990s to see such a premium on UK dividends.”
Although he noted that there have been worries about dividends recently in sectors such as oil and mining, he is quick to squash these.
“These dividends are well covered: free cashflow yields are quite a bit ahead of where they have been in many, many years,” said Casey.
“In the areas where there has been dividend worry, particularly in energy which is a big weight in the index, we’re seeing very strong, positive free cashflow rates.”
Casey said utilities and mining are two other sectors that are seeing high pay-outs and high levels of free cashflows.
Overall, he said: “I think we’re going to get more dividend growth in the UK than expected.”
Looking elsewhere in the UK, Casey said that the mergers and acquisitions going on in the UK more recently are an indication of a positive attitude towards the market.
“One of the biggest contradictions in the UK market today is that nobody outside the UK really owns the UK,” he said.
There have been many takeover bids, both successful and unsuccessful, on UK-listed companies that suggests corporates are picking up on something that investors are not.
“If it isn’t Shire Pharmaceutical 60 per cent premium being offered from a Japanese company, it’s the attempted bid on Smurfit Kappa from a US peer in the paper and packaging business.”
Meanwhile, US supermarket giant Walmart now owns a controlling stake in Sainsbury’s, Asda and Argos thanks to the recent merger, he noted.
Casey said: “It’s in the papers almost every day. Comcast and Disney in a price war for Sky: that’s a domestic business here in the UK. What are they seeing there?
“I could go on all day, there are so many attempts on UK businesses. What do longer-term, corporate, industrialist-type competitors see in UK plc that global investors are missing?” he said.
Within the UK market, one area the Schroder manager finds attractive at the moment is the domestic retail banking sector.
“The UK retail banking space is price rational, we’ve got conduct charges fading and the big risk is loan losses,” he said.
“On account of that, I don’t think loan losses are a huge risk in the UK banking space right now. Why? There is lots of value in the housing stock, at 45 per cent it’s one of the lowest it has been in decades and unemployment is the lowest it has been since the mid-seventies.”
In Casey’s view, with stable loan losses and price rationality, the UK’s retail banking market is pretty consolidated. For him, it means these companies will start increasing their dividend pay-outs.
“So these banks generate quite a lot of capital, particularly as these conduct charges fade,” said the manager. “What does that mean? It means they can start paying dividends again and grow those dividends.”
Casey took over the £933m Schroder UK Alpha Plus in March this year alongside co-manager Nick Kissack and the pair have seen it slightly outperform their average peer and benchmark since that time.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
The fund aims to invest in quality businesses that have been mispriced by the market, with the likes of oil giant Shell, pharmaceuticals business GlaxoSmithKline and Lloyds Banking Group among its top 10 holdings. It has a yield of 2.52 per cent and a clean ongoing charges figure (OCF) of 0.91 per cent.
The pair also took over the Schroder European Equity Absolute Return fund in May this year, which has marginally underperformed its average IA Targeted Absolute Return peer.